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Inflation Slowdown Complicates Fed’s Task

Prices rise more slowly for goods ranging from autos to healthcare.

Five years into the U.S. economic expansion, inflation shows little sign of picking up as prices rise more slowly for goods and services from automobiles to medical care, complicating the Federal Reserve’s drive to guide the economy away from the precipice of deflation.

The personal consumption expenditures price index, minus food and energy costs, rose 1.2 percent in 2013, matching 2009 as the smallest gain since 1955. Of 27 categories of goods and services in the gauge, 18 showed smaller price increases over the past two years, according to data compiled by Bloomberg.

The slowdown has been broad-based, with durable goods such as autos, nondurables like clothing and services including health care all playing a role. Fed policy makers are on guard to keep such disinflation from morphing into outright deflation, a persistent drop in prices that prompts households to delay purchases in anticipation of even lower costs and leads companies to postpone investment and hiring.

“There’s a lack of pricing power in most areas of the economy,” said Laura Rosner, an economist at BNP Paribas SA in New York and a former researcher at the New York Fed. “In certain months we see weakness in medical care, and then that passes on to apparel prices in other months. It’s a weakness that never quite fades.”

Investors predict subdued prices. The five-year breakeven rate, a market gauge of inflation expectations over the next five years based on trading in inflation-linked Treasuries, was at 1.94 percent yesterday, down from 2.3 percent last year at this time.

Tame inflation will allow Fed policy makers to keep interest rates lower for longer as they try to nudge price increases closer to their goal of 2 percent a year.

While inflation expectations appear to be “well-anchored,” low inflation remains a “bit of a puzzle,” St. Louis Fed President James Bullard said in New York this morning.

Fed Chair Janet Yellen has said she sees the weakness in prices as temporary, with the inflation rate likely to move back toward 2 percent “over the coming years.”

Transitory Factors

“Some of the recent softness reflects factors that seem likely to prove transitory, including falling prices for crude oil and declines in non-oil import prices,” Yellen said in testimony yesterday before the House Financial Services Committee.

A 1.2 percent year-over-year rise in the core PCE price index in December compares with a 1.9 percent gain in 2011, according to figures from the Commerce Department. The 0.7 percentage-point decline is almost evenly spread among the three main categories, with nondurable goods making up 0.3 percentage point of the slowdown and services and durable goods each contributing 0.2 percentage point, according to figures compiled by Bloomberg.

The health-care industry helped hold down prices in all three categories, the result of Medicare reimbursement cuts and substitution of generic drugs for medications losing patent protection. Medical goods and services together accounted for about a third of the drag on core inflation over the past two years.

Drug prices will remain subdued as more patents expire, allowing additional competition from generics, said Michael Manns, a health-care analyst at Bloomberg Industries. What’s more, demand for care remains subdued as patients put off check- ups and procedures in a sluggish economy. And hospitals are cutting costs by forming groups to purchase medical devices, he said.

The auto industry is still helping drive down inflation, even as it completed its best sales year since 2007. Of the 0.7 percentage-point slowdown in inflation the past two years, motor vehicles and parts were responsible for about 0.1 percentage point as low borrowing costs and discounting helped draw Americans into showrooms.

Also holding down inflation was slow growth or declines in the prices of investment advice, baby clothes, televisions, dishes and mobile phone calls.

More Widespread

There are indications that disinflationary pressures are becoming more widespread in the economy. A measure of the distribution of inflation by the San Francisco Fed shows that 20.5 percent of expenditures it tracks had lower prices in December 2013 than a year earlier. That’s almost double the 11.7 percent it found for the 12 months ended in December 2012. The number of items with lower prices was 36 percent of the total in December 2013, compared with 22.2 percent a year earlier.

Some companies, including Colgate-Palmolive Co., are resisting pressure to keep cutting prices. As the world leader in toothbrush sales, New York-based Colgate won’t “seek to chase what we think are unsustainable promotional efforts,” Chief Executive Officer Ian Cook said on a Jan. 30 earnings call.

“We’re not going to abandon sensible business principals just to chase market share,” he said.

Economists at UBS Securities LLC are among those who say pricing power will pick up along with the economy.

“Pricing is being driven by something other than weakness” in demand, said Sam Coffin, a UBS economist in Stamford, Connecticut. Influences on the supply side, such as automakers discounting to gain market share or overseas apparel makers cutting costs, were responsible for about 75 percent of the slowdown in inflation in four categories -- financial services, motor vehicles, clothing and health care, he said in a study published in May.

Coffin estimates the core PCE index will rise 1.8 percent this year from 2013, accelerating to 2.4 percent in 2015.

That view is at odds with the consensus outlook. The median projection of economists surveyed by Bloomberg calls for a 1.5 percent rise in the core index in 2014, followed by a 1.8 percent increase next year.

The case for tame inflation ahead is buttressed by stabilizing housing costs, one of the few forces that was underpinning price increases in recent years. Not counting housing, inflation would have decelerated another 0.4 percentage point in the two years ended in December, according to data compiled by Bloomberg.

Rents won’t rise as fast as they have in the past couple of years, said Jeffrey Langbaum, a real estate analyst at Bloomberg Industries.

New Apartments

“Rents are going to continue to go up, but the pace of that growth is going to slow,” Langbaum said. “The driving factor behind all that is there’s been an influx of new apartment supply,” which will help keep a lid on rents this year.

Slowing prices in the U.S. may give the Fed room to maintain historically low borrowing costs even as the jobless rate races down to a 6.5 percent threshold that policy makers have said must be reached before they will consider raising the target interest rate.

The Federal Open Market Committee said Jan. 29 it will cut monthly bond-buying by $10 billion to $65 billion, citing labor market improvement and a pickup in growth. The trimming keeps the Fed on pace to end its unprecedented asset purchase program by the end of the year.

At the same time, the Fed left unchanged its statement that it will probably hold its target interest rate near zero “well past the time” that unemployment falls below 6.5 percent, “especially if projected inflation” remains below the committee’s longer-run goal of 2 percent.

In following inflation, Fed policy makers prefer to use a personal consumption expenditures price index that includes all items, including food and energy. By that measure, prices rose just 1.1 percent in the 12 months ended in December.

“The Fed will have to acknowledge that inflation has remained lower than they forecast, and that that means they’ll remain easy even longer than they’re currently signaling,” said Michael Hanson, a former Fed economist who is now senior U.S. economist for Bank of America Corp. in New York.

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